|Summary: A spike in bond yields since May are likely overdone, with yields still at historically low levels.This is unlikely to change is unless the Fed cuts monetary easing materially or actually halts the program.|
|Key take-out: Current policies unlikely to drive bond yields much further.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
Talk of a QE tapering by the US Federal Reserve has seen US bond yields rise from a low point of about 1.62% in May to about 2.47% now - 2.7% at the peak. You can see from the chart that we haven’t seen rates like this for some time - two years to be exact.
Naturally enough, the talk is that rising yields might throw the economy off course. Even the Fed are concerned, stating the resultant tightening in financial conditions was an unwelcome development. And it’s not just a US concern - Australian bond yields also shot up - 100bp at the high to 4% - to be at 3.66% or 66bp higher since May. The argument applied to the US could equally apply here, especially as many are convinced we are headed for a downturn.
Now upfront, I’m not convinced these concerns are entirely warranted and there are several very good reasons for that.
For a start, and at a very basic level, even with the 100 basis points rise, yields are still around record lows. Indeed even with another 100bp to 3.5% - or even 4% - yields would still be very low. Take a look at Chart 2 below showing the US 10 year bond yield over a longer time horizon.
You can see from the Chart that even if rates spiked another 150bp that would only take them back to the average of the last decade - a little below actually - and rates at that level certainly did nothing to stop a credit fuelled housing boom. Also consider during this time, the US and Australian economies were recording solid to strong growth rates, broad-based jobs growth.
I think part of the problem that many analysts have, is they assume changes in interest rates always have a linear impact. That is, a 25bp move, or what have you, always leads to an x% change in real economic activity. This is far too simplistic and at ultra-low rates is most certainly wrong. Think of your own behaviour. If mortgage rates go from 5% to 4% that’s unlikely weigh heavily in the decision to buy a property. It certainly affects how much you can borrow, but not the decision to borrow by itself.
Think of what we have now then; the S&P500 hitting new records, a resurgent t house price boom in many US cities (some posting record growth). Private sector employment gains have been strong, and a private sector economy that is experiencing stronger growth now than prior to the GFC. With that in mind, I think it’s a little disingenuous to suggest that a 1% (or more) rise on bond yields from record lows, would by itself, jeopardise things.
That’s not to say that these moves wouldn’t be destabilising for the market and for investors - absolutely they would and as I’ve noted before, it is a key risk. Similarly, and depending on the longevity of any market ructions, this could weigh on business and consumer confidence which may, over time, trickle down to the real economy -- just as we are seeing in Australia now. But, my point is it’s wrong to assume that the rise in yields itself, all else equal, could jeopardise things. Only the panic could, and recent experience tells us that panic over things like a Grexit (the name given to fears Greece would be forced to leave the EU at the height of the debt crisis), double dip etc, while weighing, haven’t stalled solid economic outcomes --in the US at least.
Don’t forget, these arguments were presented the last time the Fed exited extremely low rates - back in 2004 -- and there are evaluable lessons to learn from this experience. Recall that from 2004-07, the Fed raised the target funds rate (overnight rate) from 1% to a peak of 5.25% in 2006. Over that time, GDP growth accelerated from an average of about 2.1% to 3.1%, the unemployment rate went from 5.7% to 4.4%, housing starts surged 10% on average over that period and the lift from the 2003 low to the 2006 peak (when bond yields also peaked) was 42%. US home builder stocks surged and on the ASX, James Hardie rose 92%. Rising bond yields had no discernible impact. Through that may have something to do with another issue: how much higher yields are likely to go anyway?
The last time the Fed exited a low rate environment, back in 2004, bond yields really didn’t move too much - 180bp trough to peak - and it was noted as something of a ‘puzzle’ at the time. But you can see from chart2 above, yields really were quite stable. Some readers may remember that high savings rate in Asian economies were blamed. That by itself suggests that a new and relative low equilibrium might be reached once again should the Fed exit QE - and at rates quite bit lower than the average from 2004 given short-term rates won’t be changed. As Bernanke has repeatedly said, there is no tightening in monetary policy being proposed.
At the moment, the consensus is that the Fed will begin to taper QE at some point this year. Now assuming they do, the consensus is also that they will do so by a modest amount. So for instance taper from current purchases of $85 billion ($45 billion Treasury’s and $40 billion mortgaged- backed securities) per month to something like $65 billion or $75 billionn or something similar to that.
The key point to note though is that even at that point, the Federal Reserve will effectively (indirectly) be buying most bonds the US Treasury issues for the year. Take a look at chart 3.
For 2014, the estimated budget deficit is about $580 billion, dropping to about $390 billion in 2015. That equates roughly to a financing need of $48 billion per month (met by Treasury issuance) in 2014 and $32 billion in 2015. So even if they taper, they’ll be buying directly or indirectly through mortgage backed securities (through a balance sheet switch with banks). Moreover we know the Fed isn’t selling down any bonds. This is critical as the Fed is the single largest holder of US Treasuries, holding by itself just under 20% of all US Treasuries outstanding. Throw in other government agencies and 50% of all US Treasuries outstanding are held on the public account.
To my mind that means there is a significant cap on yields - certainly over the next 12 months. That that is unless the Fed cuts QE materially or actually halts the program - - not expected till mid-next year at the earliest. Don’t forget also that the Fed will only allow a tapering or an exit if financial conditions allow. At present, the Fed has said that the current lift in yields represented an unwelcome tightening in financial conditions, not to mention the strain this would put on bank balance sheets - you put both of those together and you have an unofficial bond yield target. The fact is that if rates look like they are going too high, the Fed won’t taper, or may even lift QE (something Fed officials have repeatedly said they could do, especially with low inflation).
So for mine, it’s not likely in my view that bond yields are really going to have a material impact on the real economy. Moreover, on current policy settings and guidance, yields are unlikely to push much higher in any case.